Execute A Strip – Profit From Increased Volatility

Introduction To A Strip Option Strategy

A strip is an options trading strategy with a bearish bias. For every call bought, 2 puts are bought as well. These options have the same strike price, same expiration date and are derived from the same underlying security.

Due to the greater number of long puts employed, the strip’s profit increases at a greater rate when the price of the underlying security decreases as compared to when the price of the underlying security increases.. This explains the steep gradient shown in the payoff diagram when the price of the underlying security decreases.

Strip – Net debit

The strip consist of long puts and calls. Hence, the trade is established on a net debit. The trader’s account is deducted when the trade is executed.

Disadvantage of a strip

The disadvantage of a strip is that it is relatively more expensive than a straddle to establish as the number of long puts to long calls is in the ratio of 2 : 1.

It is important to perform economic, fundamental and technical analysis. At this point, the options trader is looking out for events or announcements that will cause volatility in an underlying security to increase. The options trader will also examine the charts and analyse the reaction of the underlying security to a particular event. Some chart patterns to look out for are :

It is important that the trader executes the trade before the breakout occurs so as to capture as much profit as possible.

The options trader who executes a strip is anticipating increased volatility levels of the underlying security within the life of the options involved. The strip has a bearish bias because there are more long put options than long call options in a strip. In essence, the trader is betting that there is a greater probability of the price of the underlying security making a significant downside move than a significant upside move.

The worse case scenario is when the price of the underlying security stagnates and trades at the strike prices of the calls and puts on expiration. When that happens, the options expire worthless and the trader loses the net debit.

The loss of a strip is limited to the net debit incurred when the strip is established. The maximum loss occurs when the price of the underlying security is equal to the strike prices of the puts and calls. Do not that the puts and calls are at the money and therefore have the same strike price. At this price point, the long calls and puts expire worthless.

The strip has an unlimited profit potential. A large profit is realisable when there is price move of large magnitude upwards or downwards.The gradient of the graph is steeper when the price of the underlying security decreases as compared to a price increases in the underlying security. This means that the profit increases at a faster rate when there is a price decrease in the underlying. This in turn, can be explained by the prevalence of using more long puts than long calls in the ratio of 2 : 1.

In general, a profit is realisable when:

The price of the underlying security is greater than the upside breakeven point

The price of the underlying security is less than the downside breakeven point

Even if it is just an estimate, calculating the risk and reward ratio is necessary to find out the attractiveness of the trade, compared to other trades. If the trade’s risk and reward ratio is not attractive, perhaps,the trader should consider executing another strategy or wait for a better opportunity to execute the strip. The reason is because executing a strip requires paying heavy commissions. Hence, the magnitude of the price movement must more than compensate for the costs incurred in the strip. Perhaps you could ask yourself of a strap or a straddle make more sense instead.

All options involved have the same strike price, same expiration date and are derived from the same underlying security. The ratio of calls to puts is thus 1 : 2 and is to be adhered to as the strip strategy has an bearish bias.

Price of underlying < downside breakeven point – If this happens, the trade can be closed at a profit.. An options trader can also decide to sell to close the put and hold onto the call options for a price reversal in the underlying security.

Downside breakeven point < Price of underlying < Upside breakeven point -If this happens, the trade is currently in loss territory. At this point, if there is little time and little chance that the price of the underlying security will make a significant move, the trader can choose to close the trade and incur the loss. The maximum loss is equal to the premiums or net debit paid for the options.

Price of underlying > Upside breakeven point – If the price of the underlying security moves above the upper/upside breakeven point, the trader can close out the trade totally. If he is of the view that there will be a price reversal, he can close the call position for a profit and hold the worthless put options to profit from the price reversal.

After the strip has been exited, the trader should record and detail the trade in a diary. Details such as profit, loss, entry and exit price should be recorded in the diary. The trader should then reflect on trade and make effort to improve on the trading process.

The price of ABC Corp is trading at $60 currently in the middle of November. A trader executes a strip by buying 2 Dec 60 puts and 1 Dec 60 call where each option contract costs $250. Hence, in total, the trader pays:

$250 x 3 = $750

The trader incurs a net debit of $750 to establish the strip.

This is also the maximum and limited loss that he will incur if the price of ABC stagnates till the expiration date of the options involved. With a greater number of puts, the trader stands to earn a greater profit with a decrease in the price of the underlying security rather than the same magnitude of increase in the price of the underlying security.

Let us examine 3 different scenarios.

When the price of ABC Corp trades at $60 on expiration of the options:

Beginning value

Ending value

Profit(+) or Loss(-)

Long 1 Dec 60 call

$2.50

$0

-$2.50

Long 2 Dec 60 puts

$5

$0

-$5

Overall loss per share

-$7.50

The total loss when the price of ABC trades at $60 is thus:

$7.50 x 100 = $750

When the price of ABC stagnates at $60, the trader earns a maximum loss of $750.

When the price of ABC Corp trades at $50 on expiration:

Beginning value

Ending value

Profit(+) or Loss(-)

Long 1 Dec 60 call

$2.50

$0

-$2.50

Long 2 Dec 60 puts

$5

$20

+$15

Overall profit per share

+$12.50

Each put contract is worth $10 on expiration. Hence, the ending value of both contracts when totalled is $20. The total profit can be calculated as:

$12.50 x 100 = $1250

When the price of ABC Corp trades at $70 on expiration:

Beginning value

Ending value

Profit(+) or Loss(-)

Long 1 Dec 60 call

$2.50

$10

+$7.50

Long 2 Dec 60 puts

$5

$0

-$5

Overall profit per share

+$2.50

$7.50 – $5 = $2.50

The total profit is :

$2.50 x 100 = $250

Compare the increase in $10 versus the decrease of $10 of the price of the underlying security, You will find that a $10 decrease resulted in a $1250 profit while a $10 decrease resulted only in $250 of profit.

Cost of establishing a strip vs a long straddle

Cost of s strip

$750

Cost of a long straddle

$500

Using the example above, if a straddle were to be used instead, the cost of establishing the straddle would be cheaper. However, at a price of $50 in the underlying security, the straddle will earn a total profit of only $500 while the strip will earn $1250.

Strip, strap, long straddle

A strip, strap and long straddle are similar strategies that anticipates an increased volatility in the price of the underlying security. The potential profit is unlimited while the loss is limited to the net debit of the trade. In the absence of volatility, the price of the underlying security will not fluctuate as much and these trades stand a greater probability of making a loss.

Strip vs strap

The main difference between the strip and the strap lies in the ratio of long puts to calls. It is highlighted below.

Long put to call ratio

Strip

2 : 1

Strap

1 : 2

The strap has a slightly bullish projection with more long calls than puts.